by Olivier Jeanne, Peterson Institute for International Economics
and Anton Korinek, University of Maryland

September 2010

The interaction between debt accumulation and asset prices contributes to magnify the impact of booms and busts in an economy. Increases in borrowing and in collateral prices feed each other during booms. In busts, the feedback turns negative, with credit constraints leading to firesales of assets and further tightening of credit. Prudential policies could be used to mitigate the build-up in systemic vulnerability during a boom. However, there are few formal welfare analyses of optimal policies to deal with booms and busts in credit and asset prices. In this paper, the authors attempt to fill the gap with a dynamic optimizing model of collateralized borrowing. The economy suffers from excessive volatility, i.e., large booms and busts in both credit flows and asset prices. Jeanne and Korinek show that a Pigouvian tax on borrowing may induce individual borrowers to internalize these externalities and increase welfare. They calibrate the model with reference to the US small and medium enterprise and household sectors and find the optimal tax to be countercyclical, dropping to zero in busts and rising to approximately half a percentage point of the amount of debt outstanding in booms.